Asset Management

Markets driven by heightened focus on Europe and mounting growth challenges

William Riegel, Head of Equity Investments
Lisa Black, Head of Global Public Fixed-Income Markets

June 29, 2012

During an eventful week that included a much-anticipated European summit meeting, an important Supreme Court healthcare ruling and a number of significant economic releases, global equity markets staged a late-week recovery that more than offset earlier declines. Low expectations for progress in addressing European debt issues were abruptly revised following the announcement of plans agreed upon during the European summit meeting. These include the use of eurozone bailout funds to directly aid troubled banks, plans to purchase sovereign debt in Spain on equal terms with existing bond holders, and common regulatory oversight of European financial institutions. The announcement led to a sharp reduction in Spanish and Italian government bond yields, which had been viewed as approaching unsustainable levels, as well as a dramatic rally in equity markets.

Article Highlights

  • Markets were positively surprised by plans to use eurozone bailout funds to directly aid struggling banks.
  • U.S. economic indicators were mixed, but general trends point to slower growth.
  • Healthcare stocks vary in response to U.S. Supreme Court ruling.
  • Treasury yields remain low but have ticked up on easing of European fears.

All eyes on the European summit

Taking center stage for the week was the European summit meeting that took place on June 28 and 29. Sharp market declines on Monday signaled investors’ shrinking expectations for far-reaching measures that might include the issuance of common eurozone bonds or other more immediate means to address the mounting funding issues faced by Spain, Italy and other highly indebted European nations. Investors were taken by surprise on Friday by an announced agreement to create a single supervisor to oversee eurozone banks and to use Europe’s rescue fund – the European Stability Mechanism (ESM) – to directly assist troubled banks. Although ESM funding will not be implemented until the end of the year at the earliest and may not be adequate to fully address required funding needs, the plan represents an important intermediate step and indicates increased willingness to share the debt burden among European countries. The move could well be an important pivot point marking a transition from extreme bearishness to a more optimistic outlook for Europe.

U.S. economic releases point to continuing slowdown

U.S. economic releases during the week provided both positive and negative signals, but on balance pointed toward continued weakening and vulnerability to the slowdown gripping Europe.

Most encouraging were indications of an uptrend in housing markets, including:

  • A third consecutive monthly increase in metropolitan home prices in April, based on the Case-Shiller index
  • New home sales in May that topped forecasts
  • Pending home sales that reached the highest levels of the year
  • Strong earnings from a number of home builders.

However, despite an increase in durable goods orders and a better Chicago Institute for Supply Chain Management report, which represented a reversal from two previous monthly declines, manufacturing activity appears to be slowing. In addition, lower consumer confidence, flat consumer spending and corporate earnings revisions that continue to slant negative reflect growing macroeconomic concerns and reduced demand from Europe. Meanwhile, continued slowing in China’s economy has driven sharp declines in oil, copper and other commodities.

Given the clearer signs pointing toward economic slowing, many now will look to Ben Bernanke’s attendance in late August at the Jackson Hole conference for a possible announcement that could signal another round of Fed quantitative easing, perhaps in September.

Supreme Court upholds healthcare law

On Thursday, the Supreme Court voted to uphold key provisions of the Affordable Care Act. The healthcare legislation signed into law in 2010 by President Barack Obama requires U.S. citizens to carry health insurance or pay a tax penalty.

This ruling will likely impact certain healthcare sector securities much differently than others:

  • Hospitals and labs in particular will likely benefit from individuals’ greater access to healthcare afforded by the law.
  • The impact of the ruling on pharmaceutical providers, medical device manufacturers and biotech companies is expected to be relatively benign.
  • Health maintenance organizations (HMOs) with a Medicaid focus are likely to benefit from expanded Medicaid coverage, while more diversified HMOs will likely face increased pressure on earnings due to newly created healthcare insurance exchanges.

While the ruling has resulted in short-term volatility, the market may benefit from improved investor sentiment based on the removal of a significant unknown factor that has been weighing on the sector.

Yields remain at low levels but begin to reflect reprieve from European concerns

In fixed income markets, concerns over Europe drove yields on ten-year and thirty-year Treasury bonds lower through Thursday, while reversing course on Friday. Spreads on investment-grade and high-yield bonds have been fairly stable and remain largely dependent upon developments impacting Europe.

The extension of the Fed’s Operation Twist and the increased likelihood of another round of quantitative easing may have implications for certain fixed income sectors, particularly for lower-coupon mortgage-backed securities, which have been the target of previous Fed purchase and could likely be the target of future purchase programs.

Cautious optimism

As reflected in the sharp uptick in equity markets following announced plans for improved mechanisms to address Europe’s debt crisis, investors are eager to view developments in a positive light despite risks that remain. When expectations for improvement and market valuations have been reduced to low levels, as they have recently, modest positive developments can easily lead to a reduction in fear, better growth and higher financial markets. However, that optimistic hope is tempered by the very real slowing of U.S. activity, which we are monitoring closely.